Investing in stock markets: What is actually a stock market index?

Have you ever stopped to wonder what an ETF is actually tracking when it follows a particular index? Let's take a look deeper into the past and present of the stock market for answers.

A stock market consists of the buyers and sellers of shares in the publicly traded companies of some particular country or region.

Share trading is typically conducted via a stock exchange. For hundreds of years these were physical spaces where people met to buy and sell shares, dealing through intermediaries called market makers. Today's stock exchanges are generally electronic in nature.

Stock markets enable investors of all means to acquire stakes in businesses by purchasing their shares, and to later realize their value by selling them.

In addition, stock market listed companies can raise capital by issuing more shares, which may be advantageous compared to taking on debt – both for the company, and also for investors prepared to accept the greater risk of share ownership in exchange for potentially higher rewards.

Without shares traded on stock exchanges, it would be much more costly to take ownership stakes in companies, which would likely prohibit all but company founders and wealthier investors from buying into them.

As we'll see, modern innovations such as Exchange Traded Funds (ETFs) have made it even easier for anyone to acquire a diversified portfolio of shares.

The birth of the stock market

The genesis of modern stock markets stretches back to Europe. Bankers initially traded government securities, but in the 17th Century the first East India companies were formed as joint-stock companies. This development enabled shares to be traded, too.

The Dutch East India Company was founded in 1602, and the Amsterdam Stock Exchange is usually credited as the world's first stock exchange.

The London Stock Exchange emerged out of informal trading in London coffee houses that began towards the end of the 17th Century. By 1773 a group of London brokers had created a purpose-built space with a dealing room on the ground floor and a coffee room above, naming it The Stock Exchange. This was followed in 1801 by London's first regulated exchange.

Today's stock exchanges are huge businesses at the heart of capitalist economies. The value of UK companies listed on the London Stock Exchange's main market, for example, was £2.3 trillion as of January 2015.

As the name indicates, Exchange Traded Funds (ETFs) are also traded on stock exchanges, and they give you an easy way to track a chosen stock market index.

Which leads us to the next obvious question…

What is a stock market index?

An index measures the performance of a particular selection of shares (or other securities, such as bonds) that are traded on a market.

The selection to be measured is determined by the company that devises the index (the index provider).

You might think of a stock market index as like a theoretical portfolio of shares, assembled according to certain rules.

The most commonplace rules for inclusion in a share index are:

Where a company is listed

The company's size (its market capitalisation)

For instance, the FTSE Group's FTSE 100 index is an index of the 100 largest companies by market capitalisation that are listed on the London Stock Exchange.

There can be many other rules, however. For example index providers often restrict eligibility on the basis of the business sector where the company operates, such as finance, energy, or real estate.

This enables the provider to create indices that measure the performance of particular sectors of the stock market.

Finally, the index provider has to decide how much each eligible security should contribute to the performance of their index. This is known as the weighting.

The most common method is market capitalisation weighting, where the index simply mirrors the relative market capitalisations of its different constituents.

Other methods include equal weighting and fundamental weighting.

We'll look at these in a future article.

ETFs make it easy to track indices

The market valuation of the securities in an index will change over time, and this is reflected in the rise and fall in the level of the index.

This fluctuation enables investors and others to study the performance of indices in order to understand how different areas of the stock market are behaving.

Also, indices are not static. Companies can leave an index and be replaced by new companies, according to the rules devised by the index provider

By itself, an index is just a measurement tool. Index-tracking funds such as ETFs make indices investable, by seeking to match the returns from a specific index.

By buying an ETF therefore, you can easily and cost-effectively match the returns from different areas of global stock markets.

The key is to determine the index that best reflects where you want to invest your money, and then to locate the most appropriate ETF that tracks the index.